The Looming Battle over Sovereign Wealth Funds

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Congress continued to express concern about the future of sovereign wealth funds and their potential threat to the American economy and foreign policy. But Securities and Exchange Commission and Federal Reserve officials tried to ward off efforts to regulate the foreign government-run funds too quickly.

Speaking before the Senate Committee on Banking, Housing and Urban Affairs, Ehiopis Tafara, director of the SEC’s office of international affairs, said that despite the potential risks posed by sovereign wealth funds, forcing heavy restrictions on them could be a solution that brings other problems.

“If we were to prohibit sovereign wealth funds from investing in our market for fear they might introduce market distortions, there is a risk we might actually end up doing precisely this ourselves through the prohibition,” Tafara said.

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Instead of prohibiting them, Tafara suggested, regulators should be focusing on transparency, independent regulation, and finding ways to avoid conflicts of interest and politicization of investments. International bodies such as the International Monetary Fund and the European Commission are already at work developing a code of conduct for sovereign wealth funds. Tafara said that more need exists in creating clarity in such areas as investment positions and asset allocation, ownership rights, the use of leverage, the size and source of resources, and regulation within a fund’s own home country.

Scott Alvarez, general counsel for the Federal Reserve, also struck a conciliatory note, observing that sovereign wealth funds have been around for many years, and thus far, despite greater attention, thes fund have not taken big enough stakes in banks to warrant review. Moreover, despite their rapid and recent growth, sovereign wealth funds still have less total investment under management globally than do pension funds, insurance companies, or investment companies.

“They are agreeing to be passive investors at this stage,” Alvarez said, arguing that it seems to soon at this point to change laws governing the foreign funds.

Some legislators were more skeptical. Sen. Christopher Dodd, committee chairman, wondered if sovereign wealth funds were purposely investing just below U.S. thresholds as a way of avoiding greater disclosure. “I’m very concerned that we’re being gamed a bit on all of this,” the Connecticut Democrat said, while acknowledging that discouraging sovereign wealth funds could also cause distortions.

More critical was Alabama Republican Richard Shelby, who argued that sovereign wealth funds would not bother to make big investments in American firms purely for economic reasons. “I’m afraid we’re going to be owned and controlled by countries and sovereign wealth funds,” Shelby said. “Who’s going to influence this country? Will it be the American people, or other people who own us?”

For its part, the SEC does have tools to enforce wrongdoing by sovereign wealth funds. Tafara said that the commission regularly works with its international counterparts, and that “sovereign immunity” does not extend to funds’ behavior in U.S. markets.

Sovereign wealth funds are estimated to hold some $2.5 trillion in assets, according to the SEC. And that amount could skyrocket to $12 trillion during the next eight years. The have drawn attention lately because of their investments in banks and companies rather than just foreign government bonds.

Firms have been appreciative of the much-needed liquidity during the current credit crisis, but regulators continue to keep a watchful eye. Last February SEC Chairman Christopher Cox played down their influence, noting that the funds represent just 1.2 percent of assets invested globally. He did acknowledge that their rise does “warrant attention”.